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Don’t tax credit unions…or community banks, either

With the suggestion box now clamped shut for the Senate Finance Committee’s tax reform project, it bears pondering what the process is likely to mean for the future of credit unions’ tax exemption.

Under the “blank slate” process laid out by Chairman Max Baucus, D-Mont., and Ranking Member Orrin Hatch, R-Utah, the committee will start with a tax code proposal that zeroes out every credit, deduction and expenditure, with members invited to make an affirmative case for any exceptions to that flat tax that they see as essential. Senators had until July 26 to submit their ideas.

If Hatch and Baucus are to be believed, the content of individual senators’ reform ideas under the lock-and-key of strict confidentiality for the next 50 years. While we at R Street are broadly supportive of the concept of zero-based budgeting, we were among a number of groups to express skepticism with the idea that the process would be more effective taking place under the cover of anonymity.

Fortunately, for the sake of open democracy, there were a number of senators who stepped forward on their own to disclose their tax reform proposals. Unfortunately, for credit unions, just one of them (Alaska Democrat Mark Begich) took a public stand that credit unions’ exemption from federal income tax should be preserved.

That Begich was the only senator to make his support public does not, of course, mean that he’s the only member who would vote to retain the tax exemption. Nonetheless, given the full-court lobbying press put on both by the American Bankers Association and the Independent Community Bankers of America to gin up anti-credit union sentiment, there are real and understandable questions about whether the exemption would survive in any forthcoming tax reform bill.

Of course, there remain big questions about whether tax reform will happen at all. Congress will leave town today for its month-long August recess, and return in September with quite a lot of unfinished business on its plate. Baucus has promised to mark up a comprehensive reform plan this fall, and his House counterpart – Ways and Means Committee Chairman Dave Camp, R-Mich. – recently pledged to keep to a similar schedule. Alas, Senate Minority Leader Mitch McConnell, R-Ky., has more or less put the kibosh on such talks:

Honestly I don’t see how we get there,” McConnell said. “It’s pretty clear that the president has even walked away now from the commitment he made to us at lunch that corporate tax reform would be revenue-neutral.

If tax reform moves forward, and if the credit union tax exemption ends up under the microscope (two very big ifs), one can expect the debate will roughly play out like this:

Credit unions will note that they are not-for-profit, community-based organizations that serve traditionally underserved populations, and that stripping the tax exemption will reduce competition and curtail credit.

Banks will argue that credit unions’ tax exemption gives them an unfair competitive advantage and costs the Treasury about $2 billion a year.

Credit unions will respond that there are thousands of banks that are organized as S Corps who pay no corporate tax; that the big international banks don’t pay taxes on their foreign source income; and that through TARP and the small business lending fund, the federal government already doled out three-quarters of a trillion dollars to the banks — the equivalent of nearly 400 years of credit unions tax exemption.

Banks (particularly the ICBA) will note that small mutual banks lost their own tax exemption back in the 1950s, and that credit unions’ traditional common bond field of membership requirements has been so diluted since the 1998 credit union reform bill as to make their distinction from community banks immaterial.

And on and on…

This sort of “they said/we said” debate isn’t terribly helpful to anyone. Nor, to be frank, is our own ultimate position that the corporate tax is counter-productive and should be abolished altogether. It should be, but it won’t be – certainly not in this round of tax reform, or any in the forseeable future.

So given prevailing political realities, what’s needed is a proposal for financial institutions that assesses a broad, flat and low tax on profits while best enabling certain shared goals, such as encouraging savings, prudent lending and equitable allocation of credit and discouraging reckless and excessive risk-taking. In service of that broad framework, it is useful to examine what the literature has to say about the differences between banks and credit unions.

Credit unions’ small business lending is a particular area of interest for academics, in part because of an artificial cap imposed on the industry in 1998 that limits member business lending to no more than 12.5 percent of a credit union’s assets. A September 2011 study from James Wilcox of the University of California at Berkeley’s Haas School of Business found that business loans by credit unions of $1 million or less had risen substantially over the past decade, relative both to credit unions’ other loans and assets and relative to small business loans at community banks.

Wilcox found that the rise helped offset declines in business loans by banks during periods of macroeconomic stress, with credit unions offsetting four percent of the reduction in small business loans and seven percent of the reduction in total business loans by banks. Moreover, while Wilcox did find evidence that increased small business lending by credit unions displaced some bank lending, the displacement was relatively small (roughly 20 percent) and led to more net lending overall. According to Wilcox, each additional dollar in small business loans by credit unions leads to a net increase in business loans of 80 cents.

But it isn’t just in the area of business lending where credit unions have demonstrated their ability to serve members more efficiently. Here are some other noteworthy recent findings:

A June 2010 U.S. Treasury Department report from economist David Bernstein found that expanded use of credit unions would “benefit savers, borrowers, insurance funds, taxpayers and the financial system.” Bernstein concluded that credit unions offered higher interest rates to savers, lower interest rates to borrowers, less credit rationing during periods of financial turmoil, lower size-adjusted failure rates, lower insurance fund loss rates and a reduction in incentives to become “too big to fail.”

A November 2011 paper from Paul Wilson of Clemson University and David Wheelock of the Federal Reserve Bank of St. Louis looked at the growth of credit unions since 1985, a period in which their share of depository assets has nearly doubled and the average inflation-adjusted size of credit unions has increased 600 percent. Wilson and Wheelock ran regressions on credit unions’ economies of scale and found increasing returns for credit unions of all sizes, suggesting there was likely to be value in the market’s continued consolidation and growth.

David Smith of Pepperdine University’s Graziadio School of Business and Management has authored a number of reports on credit unions, finding in 2011 that credit unions’ aggregate loan portfolio appear was about 25 percent less sensitive to macroeconomic shocks than bank portfolios. Smith followed that up with a 2012 paper showing that, while commercial lending by banks declined following the recessions that started in 2001 and 2007, credit unions’ commercial loan growth rates remained positive.

Now, the banking lobby is apt to be unimpressed with these findings, as they’re likely to claim the benefits credit unions offer are only possible due to the tax exemption. But if that were true, then the push to treat credit unions more like banks (and in the process, almost certainly drive some number of credit unions to BECOME banks) makes no sense. If the goal is better, cheaper, more efficient allocation of credit, then this evidence points instead toward trying to make banks more like credit unions.

There is one obvious way to do that, and it could even be a politically palatable idea. Instead of stripping credit unions of their tax exemption, reinstate the tax-exempt status that building and loan associations, cooperative banks and mutual savings banks all held until the Revenue Act of 1951. This cohort — a much smaller portion of the financial services landscape today than it was in 1951 — represents those banks that are already most like credit unions. They, too, exist for the benefit of their members, rather than as profit-maximizing entities. And with their tax exemption restored, one expects they also would be better able to serve traditionally underserved populations than do the big, for-profit banks.

Perhaps most importantly, from a political perspective, a proposal that links community banks and credit unions arm-in-arm against the behemoth too-big-to-fail institutions that have sucked up hundreds of billions in taxpayer dollars is one that, we expect, just might be able to generate support on both sides of the aisle.